Posted by: Deepa Vasudevan on Mon, Jun 22nd, 2015

Inflation or Deflation? And why does it matter?

There has been much discussion about the appropriate inflation measure for measuring real interest rates, a debate that was largely initiated by a recent article by the Chief Economic Advisor ( The argument is that the three main measures of inflation: WPI, CPI and the GDP deflator- diverge widely from each other. As Pic 1 shows, WPI inflation turned negative last year, CPI inflation has mostly remained in the range of 4% to 6%, and quarterly inflation based on the GDP deflator (calculated simply as the difference between Gross Value Added at current and constant prices) was close to zero during the last quarter of 2014-15! Which of these represents the actual trend in price changes? Are we at zero inflation, are we suffering deflation, or is the economy facing a stable 5% inflation?


Pic 1 Inflation Measures


The divergence between various inflation measures is easily explained by the differences in their composition. WPI is driven by commodity prices, especially fuel prices. Prices of primary commodities have declined globally in the last year. In addition, since January 2015, the fuel component of WPI has dropped by an average of 12%, explaining a great deal of the drop in WPI inflation. CPI inflation is dominated by trends in food prices, which have moderated, but not fallen so steeply as to push the index into deflation. The GDP deflator covers the cost of all output produced and sold in the economy; and it shows that prices have barely moved in the first quarter. The GDP deflator rarely enters the calculations of economists and policy makers, since it is available only quarterly or annually, and with a delay. So here is what we can conclude from trends in wholesale and retail inflation: one, prices for producers are falling due to a decline in prices of primary inputs and two, the cost of living for consumers is growing at a moderate level, and within tolerable inflation limits.


This divergence sends conflicting signals about monetary policy.  The real repo rate based on WPI inflation is more than 8%, whereas the real rate based on CPI is around 1.2% (Pic 2). In other words, producers face a real rate of at least 8%, whereas consumers can expect to earn a real rate of at least 1.2%, net of their living costs.  An economy facing deflation (as measured by WPI) needs strong fiscal and monetary stimulus to revive. An economy facing stable and low inflation (as the CPI indicates) requires weaker stimuli. Thus policy decisions can be complicated when inflation numbers diverge widely, and move in different directions. Though the RBI is mandated to track CPI, it cannot ignore the WPI, which is signalling a state of deflation.


Pic 2 Real repo rate

There was a similar divergence in 2012, when CPI was much higher than WPI due to high food prices. However, at that time, the need to keep food inflation under control, ensured that the RBI ignored WPI and focused instead on controlling the double-digit CPI. This time, the situation is different, because both CPI and WPI are low.


Two points must be noted. First, CPI has been revised and rebased recently, and the new index captures the actual basket of goods consumed by an average urban and rural consumer. WPI remains stuck at the base year 2004-05; and is due to be revised soon. A revision of data sources and methodology may improve WPI data and reduce the divergence to some extent. Second, a gap of 2% to 3% between wholesale and retail inflation is normally observed. The present gap of 7% plus is a matter of concern. A revival of economic demand would restore the balance to some extent; because given falling input prices, a rise in corporate sales and profits would automatically pull up the prices of manufactured goods, and increase WPI inflation. Until that happens, policy makers have to place their bets on CPI and hope that the present monetary easing will stimulate the economic activity. 

Ajit Purohit on Fri, Jun 26th, 2015 3:22:43 pm

Excellent got a detail knowledge.

Ramesh B on Wed, Jun 24th, 2015 2:36:46 pm


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